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Accounting Unit 1 Notes: Chapter 1-The Nature and Role of Accounting in Small Business
Accounting Unit 1 Notes: Chapter 1-The Nature and Role of Accounting in Small Business
Liabilities are what business owes to external parties, while owners equity is
what the business owes to the owner, and both of these claims must be funded
from the businesss assets
The relationship- between assets, liabilities and owners equity- is known as the
accounting equation:
Assets = Liabilities + Owners Equity
The accounting equation has the same affect on all businesss, and all reporting
entities are subject to one fundamental accounting law: the Accounting equation
must balance, this means the worth of assets must always equal liabilities plus
owners equity
The equation always balances because the owner receives the residual (left over)
interest after the liabilities are deducted
The relationship- between assets, liabilities and owners equity- as described by
the Accounting equation- is the heart of the balance sheet
The balance sheet is an accounting report that details a firms financial position at
a particular point in time by listing its assets and liabilities and the owners equity
The title of the report refers to who the report is prepared for, what type of report
it is and when it is accurate
The balance sheet is always titled as at because it reflects the fact that a Balance
Sheet is only ever accurate on the day it is prepared
The elements of the Accounting equation- assets, liabilities and owners equity
provide the headings within the Balance Sheet
The usefulness of a balance sheet can be improved by classifying the information
it contains
Items in the balance sheet can be classified whether they are current or noncurrent
A current asset is a resource controlled by the entity (as a result of a part event),
from which a future economic benefit is expected for 12 months or less
A non-current asset is a resource controlled by the entity (as a result of a part
event), from which a future economic benefit is expected for more than 12 months
A current liability is an present obligation of the entity (arising from past events),
the settlement of which is expected to result in an outflow of economic benefits in
the next 12 months
A non-current liability is an present obligation of the entity (arising from past
events), the settlement of which is expected to result in an outflow of economic
benefits sometime after the next 12 months
When classifying loans it is important to recognize that some of the amount
owing may be current, and some non-current, therefore the installment of the loan
which is due in the next 12 months is current and the rest is non-current
Every transaction will change at least two items in the accounting equation, but
after those changes are recorded the Accounting equation must still balance, this
is known as double-entry accounting
Working Capital Ratio (WCR) is a liquidity indicator that measures the ratio of
current assets to current liabilities to assess the firms ability to meet its short term
debts
As long as the Working Capital Ratio (WCR) is above 1:1 then this would
indicate sufficient liquidity, as there are enough assets to cover the current
liabilities of the business
A Working Capital Ratio that is too high may indicate that the business has an
overabundance of current assets that are not being employed effectively
Stability is the ability to meet long-term obligations
Whereas liquidity focuses on short-term, stability concentrates on the firms ability
to meet its obligations in the longer term
A good indicator of stability is Gearing, which measures what percentage of the
firms assets are funded by external sources
Gearing is the proportion of the firms assets that are funded by external sources
Gearing: formula
Gearing =
Total Liabilities
-------------------Total Assets
x 100
Source documents are pieces of paper that provide both the evidence that a
transaction has occurred, and the details of the transaction itself
The information communicated to the owner via the reports is the product of the
recording system which summarises and classifies transactions. But the records
themselves are generated from the raw data provided in source documents: they
provide the facts on which all subsequent accounting information will be based
Source documents have two separate yet related functions:
1. They provide verifiable evidence of the details of a transaction, thus
ensuring that the information in the accounting reports will be
reliable- free from bias or subjectivity and accurate
2. They provide the evidence that is required by the Australian Tax
Office (ATO) relating to the firms income tax and Goods and
Service Tax (GST) obligations
Due to their importance, source documents must be stored and filed in a safe and
organized manner
GST (Goods and Service Tax) is a 10% tax levied by the federal government on
sales of goods and services
GST applies to most goods and services except fresh food
Under the current GST system, the federal government taxes consumers 10% of
the price of whatever they have purchased, with the business that sells the
goods/service acting as the tax collector for the ATO. At the same time any GST
the business pays to its suppliers will reduce the amount it owes to the ATO
The need to verify the amount of GST owed to the ATO means it is essential that
the business has accurate information relating to:
The GST it has collected on its sales or service (which it owes to the
ATO)
The GST it has paid to its suppliers (which reduces the GST owed to
the ATO)
As a consequence of GST, source documents must include the following
information:
The words tax invoice stated clearly
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Cheques means that that the owner can avoid carrying around large
amounts of cash
Cheques can be traced to identify the business or individuals that
deposited the funds into their account
The cheque butt that is retained after every payment provides
evidence of the transaction (the amount and use of cash)
The cheque itself is a document informing the bank to transfer funds from the
account of the drawer to the bank and account of the payee
The drawer is the entity writing the cheque
The drawee is the financial institution or bank of the drawer
The payee is the entity that is that is receiving the cheque or to whom the cheque
is written to
Cheques should not be made out for cash when paying for costs as if the cheque is
lost it can be cashed or deposited into any account
It is a sensible practice to nominate the payee and the cheque not negotiable, this
means that is can only be deposited into the account of the nominated payee
Not negotiable is a control mechanism that ensures that the cheque can only be
deposited into the account of the nominated payee
Even though a cheque is signed by the owner, the business is recognized as the
drawer, as the bank account belongs to the business, and its is the business that is
drawing on its account to pay for the cost
Even if a cheque is cancelled, the cheque butt should be completed so that the
cheque can be accounted for
At the time a cash payment is made, the business will pay cash for whatever it is
purchasing, plus GST on that amount, and this should be documented on the
cheque
If a business has paid any GST to its suppliers, it is allowed to deduct this from
the GST it owes; because the GST will be forwarded to the ATO by the firms
suppliers, it is treated as if the business has paid the GST straight to the
government; thus GST paid to suppliers will decrease a firms GST liability;
because of the it is possible to have a GST asset is the firm has paid more GST
than it has received
Cash payments cannot always be made in forms of cheques, alternative methods
are:
A petty cash system- under this system a small amount of cash is set
aside with individuals reimbursed from the petty cash fund for small
amounts that they have paid on behalf of the firm
The business may use debit or credit cards for purchases
Phone and internet banking to transfer cash electronically from one
account to another
Regardless of which method of payment is used, the basic principles of cash
recording still apply, and the source documents must be kept to verify thee
amount, and the use of the cash
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4. Sundries- Also the same as the Cash Receipts Journal, it allows the recording
of infrequent cash payments.
The double-checking mechanism also applies for the Cash Payments Journal
As any GST paid to suppliers will be forwarded to the ATO, thus GST paid to
suppliers decreases the GST liability
The cash journals does not provide a complete assessment of a firms cash
situation because they do not show:
The firms bank balance at the start of the period
The firms bank balance at the end of the period
The overall change (increase or decrease) in the firms bank balance
Due to the above reasons we need to prepare a Statement of Receipts and
Payments, which provide a full assessment of the firms current cash situation
As with all accounting reports the title of the statement identifies who the report is
prepared for, what type of report it is and when- which period it applies
The totals of the classification columns and the individual amounts listed in the
Sundries column are reported under the headings of Cash Receipts and Cash
Payments, depending on the journal in which they were recorded, this include a
GST column in both the payments and receipts headings
The overall change in the firms bank balance- known as the surplus or deficit- can
be calculated by deducting the total cash payments form the total cash receipts
Surplus (Deficit) = Cash Receipts Cash Payments
A cash surplus occurs when there is an excess of cash receipts over cash
payments, leading to an increase in the bank balance
A cash deficit occurs when the is an excess of cash payments over cash receipts,
leading to a decreases in the bank balance
The opening bank balance represents how much cash is available in the firms
account at the start of the period. The opening bank balance is the same s the
closing bank balance in the last period.
The closing bank balance represents how much cash is available to the firm
currently. It is calculated by adding the surplus or deficit to the opening bank
balance. It is reported as Bank in the balance sheet. If the bank balance is positive,
then Bank will be reported as an current asset; if the balance is negative then
bank overdraft will be reported as a current liability
Closing Bank Balance = Opening Bank Balance + Surplus (Deficit)
The difference between a cash deficit and a bank overdraft is; a deficit refers to a
decrease in a firms bank balance- the change- but it does not necessarily mean a
negative balance. An overdraft refers to a negative balance, it describes not a
change but a level of cash.
The Statement of Receipts and Payments summarises all information relating to a
firms cash position, this then can help the owner make decision about the firms
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receipts, payments and the level of cash on hand. A high bank balance might
indicate the ability to make higher loan repayments, take greater drawings,
purchase newer non-current assets, or undertake other expansionary activities. A
low bank balance might indicate the need for lower loan repayments, lower
drawings, the use of credit for some purchases, or even a capital contribution by
the owner.
When a business receives GST, it does so on behalf of the government, so the
business owes GST to the ATO. However if a business has paid GST to its
suppliers it is allowed to deduct this from the GST it owes. At the end of the
period the firm must calculate its overall GST balance.
As selling prices are usually higher than cost prices, GST received on fees will
usually be greater than GST paid to its suppliers. Therefore most businesses will
accrue a liability n relation to GST called GST Payable. GST payable is a
current liability, as it is a present obligation which is expected to result in the
outflow of economic benefits. When GST is payed to the ATO it is known as a
GST settlement. GST settlement is recorded in the Cash Payments Journal, and is
classified in the sundries column.
GST payable is GST owed by the business to the ATO when the amount of GST
the business has received on its fess is greater than the GST it has paid to its
suppliers
GST settlement is a payment made to the ATO be a small business to settle GST
payable
If a business makes bulk purchases of goods or purchases non-current assets, then
it is possible that GST paid to its suppliers is greater than the GST received. In
this case this is called GST receivable from the ATO. GST receivable is a current
asset as it can expect and economic benefit. A GST refund would be recorded in
the Cash Receipts Journal in the Sundries column
GST receivable is GST owed to the business by the ATO when the amount of
GST the business has paid to it suppliers is greater than the GST it has received
on it fees
GST refund is a cash receipt form the ATO to clear GST receivable
The most basic function of any small business is to earn profit for the owner
Profit is the net increase in the owners equity as a result of the firms operations
Profit is calculated by measuring the firms revenue- what it has earned from its
customers from performing a service and deducting from this its expenses- what
is
has
cost
the
business
to
provide
those
services
Profit = Revenue - Expenses
Revenue will usually be cash, but it does not have to be- it could be debtors or
even stock
Revenue will increase assets- if the service is done for cash then Bank will
increase, but services can also be done for credit so Debtors will increase
Revenue then represents an increase in owners equity that occurs through
business activities, and in most cases will be what the business has earned from its
services, not what the owner has contributed (capital contribution)
Expense is an outflow or consumption of an economic benefit (or a reduction in
inflow) in the form of a decrease in assets (or an increase in liabilities) that
reduces owners equity (except for drawings)
Where as assets refer to future economic benefits- benefits the business still hasexpenses refer to benefits to that have been consumed, and are gone
Expenses will decrease assets (or increase liabilities)- if the expense is paid in
cash then Bank will decrease, but it is possible for Stock to decrease or if paid
by credit Creditors will increase
Expenses represent a decrease in owners equity that occur through business
activities, or what the business has consumed to earn its revenues, but not what
the owner has withdrawn from the business (drawings)
Once the Reporting Period is determined, it is important that the calculation of
profit includes only revenues and expenses- this insures relevance in the reports
by including only information useful for decision making
Profit and Loss Statement is an accounting report which details the revenues
earned and expenses incurred during the reporting period
Cash receipts that are revenues are:
Cash fees- is revenue received from providing a service
Interest on bank account- a by-product of the business operating a
bank account
Cash Receipts that are not revenues are:
Capital Contribution- is not a revenue as it is not earned by the
business, but rather contributed by the owner
Loan- it does not increase owners equity, it increases bank but also
increases liabilities (loan)
GST received- it does not increase owners equity, it increases bank
but also increases liabilities (GST payable)
Cash payments that are expenses are:
Wages and Supplies- consumed in the process of providing services
Electricity (and similar)- is consumed by the business premises
Interest on mortgage- is incurred as a result of using a mortgage to
pay for the premises
Cash Payments that are not expenses are:
Mortgage Repayments- is not an expense as is does not decrease
owners equity; it decreases Bank but also decreases the liability
Mortgage
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A business cannot be successful if it does not prepare early for what it may face in
the future
Budgeting is the process of preparing reports that estimate or predict the financial
consequences of likely future transactions
The differences between the budgets and the reports that we have done before are:
1. Budgets report future events rather than historical events; they focus
on what might happen rather than what has happened
2. As a consequence budgets use estimates or predictions rather than
actual, verifiable data
Budgets have a role in both planning and decision-making:
1. Budgets assist planning by predicting what is likely to occur in the
future. This allows the owner to prepare for what is likely to occur so
that possible problems maybe managed, and possible opportunities
taken.
2. Budgets aid decision-making by providing a standard (a benchmark) against which actual performance can be measured. This
allows the owner to identify areas in which performance is
unsatisfactory, so that remedial action may be taken.
The information in a budget relies largely on what has happened before- what we
expect to happen this year will depend largely on what has happened last year
Budgeting is a part of a continuous process; budgets should be prepared ,
compared against actual reports to allow problems to be identified, decisions
should be made based on that assessment, and then new budgets should be
prepared for the next period
The information presented in the budget should be based on historical data, but
allowances should be made for changes and the effect of new business decisions
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The cash budget is an accounting report which predicts future cash receipts and
payments, determines the cash surplus or deficit, and thus estimates the cash
balance at the end of the budget period
Typical cash receipts a service firm could expect to see in a cash budget might
include:
Cash fees/takings
GST received
GST refund
Other revenue received (such as interest)
Cash contributions (capital contribution)
Loans received
Cash received from the sale of an non-current asset
Typical cash payments a service firm could expect to see in its Cash Budget might
include:
Expenses paid (such as wages, rent or advertising)
GST paid
GST settlement
Cash Drawings by the owner
Loan repayments
Cash paid for non-current assets
When reporting creditors and debtors in a budget the GST is reported as a part of
creditors or debtors- not sperately
More frequent budgets will be more accurate, and therefore more useful as
benchmarks for comparison. They will also allow for the early detection of
problems, so that corrective action can be taken in a more timely fashion (and can
perhaps stop a small problem becoming large)
It would be wise to prepare budgets for consecutive months to show the effect of
monthly variations. This will allow the owner to identify monthly or even
seasonal trends, and can be useful for identifying when to undertake a particular
cash activity (such as a purchase of non-current assets).
The cash budget aids planning by allowing the owner to prepare in advance for an
expected cash surplus or deficit. That is, the owner will be forewarned if the
business is not generating enough cash or if excess funds will be available. This
forewarning is particularly important if a cash deficit si predicted, because the
cash budget will allow the owner to take steps to address the cash shortage before
it occurs.
Should the budget predict an overall cash deficit, the owner might prepare for this
by:
Deferring the purchase of non-current assets, or using credit facilities
or a loan for their purchase
Deferring loan repayments
Taking less cash drawings
Making a cash capital contribution
Organizing (or extending) an overdraft facility
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Should the budget predict an overall cash surplus, the owner might plan to use the
extra cash to:
Purchase more/newer non-current assets
Increase loan repayments
Increase cash drawings
Expand operating activities by increasing advertising, employing
more staff ect.
Also if the business at the start of the period had an bank overdraft, it
may chose to do nothing and let the surplus bring the bank back into
surplus
The cash budget aids decision making because it sets a benchmark for the
assessment of the firms actual cash performance. By comparing budgeted and
actual cash flows, the owner can identify problem areas and act to correct the
problems. Problems identified in the budget may lead to:
Strategies to increasing cash fees (via promotion, greater advertising,
discounting prices)
Strategies to decrease cash paid for expenses. The owner must be
careful when reducing cash paid for expenses, as the benefits the
expenses provide are vital in the earning of cash takings; cutting
expenses may actually make the cash situation worse rather than
better
Cash Variance Report is an accounting report which compares actual and
budgeted cash flows, highlighting any differences (variances), so that problems
can be identified and corrective action taken
Variance is the difference between an actual figure and a budgeted figure,
expressed as favorable or unfavorable
Variances are a result of two main things:
1. The business over-performing or under-performing
2. Or a miscalculation of the budget
A variance is favorable (F) if it Bank will be higher than expected in the budget
A variance is unfavorable (U) if it means Bank will be lower than expected in the
budget
In relation to cash receipts:
If actual cash received is greater than budgeted, the variance is
favorable, as the closing bank balance will increase more than
expected.
If actual cash received is less than budgeted, the variance is
unfavorable, as the closing bank balance will be increase less than
expected
In relation to cash payments:
If actual cash paid is greater than budgeted, the variance is
unfavorable, as the closing bank balance will decrease more than
expected
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